Davos: Leaders confront their follies

People walk past the logo of the World Economic Forum in front of the congress center in the Swiss mountain resort of Davos on Jan. 22, 2012.

ARND WIEGMANN/ARND WIEGMANN/REUTERS

Martin Wolf

Financial Times

March 26, 2017January 23, 2012

What do euro zone leaders want most at the meeting of the World Economic Forum? To cease being viewed as the source of global economic threats and return to being a source of economic solutions. It is far more fun -- let alone more dignified -- to lecture others on their faults than to be lectured on one's own. It is even more humiliating when those lectures are thoroughly deserved.

Unfortunately for the euro zone, there is no chance that its policy makers will escape blame in Davos. They will argue that they are on the way to a resolution. Alas, the more percipient of them, as well as their peers from around the world, know they are not. Their visit to the Swiss mountains will be a discomforting experience.

The euro zone is almost universally regarded as the source of the pre-eminent threat of an economic meltdown. The risk is that both banks and sovereigns could default, probably triggering -- or triggered by -- a partial or complete break-up of the euro zone. Such a wreck may still be regarded as unlikely, but it is no longer inconceivable.

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Even a modest likelihood of such an extreme event creates more uncertainty than investors, still scarred by the financial crisis of 2008, are prepared to bear. The result is a flight to safety. This is seen in the very low yields on the safest assets - such as the bonds of the U.S., German and even, amazingly, U.K. governments. It is also seen in the role of the European Central Bank as an intermediary in both cross-border and interbank lending.

As Nicolas Doisy, senior economist at Cheuvreux, the French broker, remarks, "the only real guarantee of success is the price of failure". Yet history is replete with examples of failure. The rush into the euro zone is one of them. Its creators went to sea in a sieve: an agreement to create a single currency that lacked the means for financing internal imbalances, coping with financial shocks or securing needed adjustments in competitiveness. They relied, instead, on the adjustment mechanisms of the 19th-century gold standard, but without 19th-century economies or the possibility of "going off gold" in extreme conditions.

The assumption was that this sieve could -- and would -- be turned into a seaworthy ship, in the middle of a storm. This has, unsurprisingly, turned out to be hard to do.

The euro zone was cursed by its early good luck. During the optimistic period prior to the crisis, interest-rate spreads disappeared and capital flowed readily into countries such as Greece, Ireland, Portugal and Spain. Similarly, it was easy for a country such as Italy to refinance its debt mountain on attractive terms.

These heady days allowed the emergence - or preservation - of unsustainable positions: property bubbles, irresponsible lending and huge external imbalances. The mantra was even that the balance of payments did not matter in a currency union. This was wrong. The only difference was that the currency union ruled out straightforward currency crises. Debt crises were likely, instead.

When private flows stopped in 2008, a wave of interconnected private and sovereign debt problems broke upon the frail vessel. A series of desperate measures by the ECB, acting as lender of last resort to battered banking systems, member governments and the International Monetary Fund, kept the ship afloat. But it has not yet come safely to port. Worse, there has been much disagreement even over the course: important governments have changed their minds, for example, on the role of "private sector involvement" or, more bluntly, of default.

The crisis has, in consequence, spread across the banking system and the weaker sovereigns. The yields on long-term Italian government debt, even under the new technocratic government, remain at the unsustainable level of 7 per cent.

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The response of Germany, the most creditworthy and most powerful member, has been to demand ever greater fiscal stringency. In current economic conditions, that has deepened recessions without much improving fiscal outcomes. Meanwhile, the ECB is prepared to finance banks freely, but remains determined not to finance governments, at least directly. In 2012, to make things yet more stressful, a euro zone-wide recession is forecast. The euro zone must urgently reach a workable agreement on what needs to be done now and how to reform for the longer term. It is not there yet.

The proposed new treaty, with its overwhelming focus on fiscal discipline, may be a step towards such an outcome. But it is certainly not itself such an outcome. That is partly due to current account imbalances and financial excesses, for which both creditors and debtors were responsible, and that were more important than fiscal irresponsibility in causing the crisis. It is also because fiscal discipline, even allied with temporary financing, will not produce the needed adjustment in competitiveness and return to growth that is needed.

Davos is at least a suitable place to confront the possibility of a European disaster. It is where Thomas Mann, the German writer, set The Magic Mountain, one of the classics of 20th-century European literature. The theme of this work was the follies that led to the first world war. In Davos, policy makers should contemplate past follies -- and reach agreement on the imperative of avoiding further examples.

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